2019 G.

C Enron's Scandal

LEADSTAR COLLEGE OF MANAGEMENT AND

LEADERSHIP
Course Title : EDP Auditing
Department of accounting and finance

Complete analysis of enron company scandal

Prepared By: Abaynesh shiferaw

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Enron Company
Enron Company Profile
This Company was formed by the name ‘’Enron’’ in Omaha Nebraska US in 1985 by
Keneth lay. But its history dates back to 1930’s at that time it was a corporate Company of three
other companies (North American light and power company (35% share), United Light and
Railways Company (35% share) and Lone star gas corporation (30% Share) These three
companies throughout the years evolved in to two companies namely Houston Natural Gas and
Inter North. Then in 1985 this two companies were merged to form one of the biggest Natural
Gas and Electricity providing Business Company with the one of the most rapid rise and
enormous fall in US history. It marketed natural gas liquids worldwide with a transmission
system of more than 36,000 miles following was also major supplier of solar and wind renauable
every worldwide.
Enron was a public company with about 29,000 Employees, sales of 101 billion dollars in year
2000 G.C it had its head quarter at 1400 smith street Houston, Texas, United States and its
distribution scale in area included United States, India and Caribbean. Its yearly revenue in its
heydays was $100.789 billion US dollars with an income of Net $0.979 billion dollars and total
of assets $ 67,503 billion dollars. The key people of ENRON company were Kenneth Lay
(founder, Chairman and CEO) Late Jeff Skilling (former president, Coo & CEO), Anrew Fastow
(Former Vice Chairman, Chairman and CEO or Enron International) and Stephen Trauber
(Interim CEO and CRO) and Rebecca Mark-Jusbasche ( former Vice Chairman, Chairman and
CEO of Enron International.)

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Kenneth Lay Jeff Skilling

Andrew Fastow

Stephen Trauber Rebecca Mark-Jusbasche

* Pictures of the key people in Enron International *

Enron's scandal
1. About the scandal

The Enron scandal, publicized in October 2001, eventually led to the bankruptcy of the Enron
Corporation, an American energy company based in Houston, Texas, and the de facto
dissolution of Arthur Andersen, which was one of the five largest audit and accountancy
partnerships in the world. In addition to being the largest bankruptcy reorganization in
Americana history at that time, Enron was cited as the biggest audit failure.

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2 . The Causes of Enron’s scandal (bankruptcy)

2.1 Truthfulness

The lack of truthfulness by management about the health of the company, according to Kirk
Hanson, the executive director of the Markkula Center for Applied Ethics. The senior executives
believed Enron had to be the best at everything it did and that they had to protect their
reputations and their compensation as the most successful executives in the U.S. The duty that
is owed is one of good faith and full disclosure. There is no evidence that when Enron’s CEO
told the employees that the stock would probably rise that he also disclosed that he was selling
stock. Moreover, the employees would not have learned of the stock sale within days or weeks,
as is ordinarily the case. Only the investigation surrounding Enron’s bankruptcy enabled
shareholders to learn of the CEO stock sell-off before February 14, 2002 which is when the sell-
off would otherwise have been disclosed. Why the delay? The stock was sold to the company to
repay money that the CEO owed Enron—and the sale of company stock qualifies as an
exception under the ordinary director and officer disclosure requirement. It does not have to
be reported until 45 days after the end of the company’s fiscal year.

2.2 Interest

It has been suggested that conflicts of interest and a lack of independent oversight of
management by Enron's board contributed to the firm's collapse. Moreover, some have
suggested that Enron's compensation policies engendered a myopic focus on earnings growth
and stock price. In addition, recent regulatory changes have focused on enhancing the
accounting for SPEs and strengthening internal accounting and control systems. We review
these issues, beginning with Enron's board. (Gillan SL, Martin JD, 2007) The conflict of interest
between the two roles played by Arthur Andersen, as auditor but also as consultant to Enron.
While investigations continue, Enron has sought to salvage its business by spinning off various
assets. It has filed for Chapter 11 bankruptcy, allowing it to reorganise while protected from

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creditors. Former chief executive and chairman Kenneth Lay has resigned, and restructuring
expert Stephen Cooper has been brought in as interim chief executive. Enron's core business,
the energy trading arm, has been tied up in a complex deal with UBS Warburg. The bank has
not paid for the trading unit, but will share some of the profits with Enron.

2.3 An important factor: accounting fraud (using “mark to market” and SPE as
tools)

2.3.1 Mark to market

As a public company, Enron was subject to external sources of governance including market
pressures, oversight by government regulators, and oversight by private entities including
auditors, equity analysts, and credit rating agencies. In this section we recap the key external
governance mechanisms, with emphasis on the role of external auditors. This method requires
that once a long-term contract was signed, the amount of which the asset theoretically will sell
on the future market is reported on the current financial statement. In order to keep appeasing
the investors to create a consistent profiting situation in the company, Enron traders were
pressured to forecast high future cash flows and low discount rate on the long-term contract
with Enron. The difference between the calculated net present value and the originally paid
value was regarded as the profit of Enron. In fact, the net present value reported by Enron
might not happen during the future years of the long-term contract.

There is no doubt that the projection of the long-term income is overly optimistic and inflated.

2.3.2 SPE—Special Purpose Entity

Accounting rule allow a company to exclude a SPE from its own financial statements if an
independent party has control of the SPE, and if this independent party owns at least 3 percent
of the SPE. Enron need to find a way to hide the debt since high debt levels would lower the
investment grade and trigger banks to recall money. Using the Enron’s stock as collateral, the
SPE, which was headed by the CFO, Fastow, borrowed large sums of money. And this money
was used to balance Enron’s overvalued contracts. Thus, the SPE enable the Enron to convert

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loans and assets burdened with debt obligations into income. In addition, the taking over by the
SPE made Enron transferred more stock to SPE. However, the debt and assets purchased by the
SPE, which was actually burdened with large amount of debts, were not reported on Enron’s
financial report.

The shareholders were then misled that debt was not increasing and the revenue was even
increasing.

3. The role of the auditor (Arthur Andersen) in Enron's scandal

Failure of the Auditor

 Types of failures by auditors

o Auditors may either fail to detect a material error or misstatement, or, having
detected an error, fail to recognize it, because they have carried out a
substandard audit – i.e. the auditors are incompetent.

o Auditors may identify an error or misstatement and fail to report it or get the
directors to put it right – i.e. the auditors lack independence.

o Directors may deliberately deceive auditors. In cases of deliberate deception,

auditors may not be held responsible for failure to detect a problem.

In accordance with the above brief explanation Andersen’s (Enron's auditor) audit failed due to
unconscious bias which is the propensity to interpret data in accordance with our desires.
Biased judgments, rather than criminal collusion between auditors and management often
cause audit failures. The so called “integrated audit” that Andersen employed at Enron where it
sought to combine its role as external auditor with internal auditing, the process whereby an
enterprise checks its own books. Internal audits seek to ensure that an enterprise follows its
procedures, safeguards its assets, and operates efficiently. Management has historically
selected the accounting principles that an enterprise uses to prepare its financial statements.
An audit essentially endorses or rejects the accounting choices that management has made.

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The auditors have a large part of responsibility while endorsing or rejecting the accounting
principles.

Enron and the reputation of Arthur Andersen

The revelation of accounting irregularities at Enron in the third quarter of 2001 caused
regulators and the media to focus extensive attention on Andersen. The magnitude of the
alleged accounting errors, combined with Andersen's role as Enron's auditor and the
widespread media attention, provide a seemingly powerful setting to explore the impact of
auditor reputation on client market prices around an audit failure. CP investigates the share
price reaction of Andersen's clients to various information events that could lead investors to
revise their beliefs regarding Andersen's reputation.( Nelson KK, Price RA, Rountree BR, 2008)
Perhaps most damaging to Andersen's reputation was their admission on January 10, 2002 that
employees of the firm had destroyed documents and correspondence related to the Enron
engagement. For a sample of S&P 1500 firms, CP reports that in the 3-day window following the
shredding announcement (0, +2), Andersen clients experienced a significant −2.03% market
reaction, and this reaction was significantly more negative than for Big 4 clients. Andersen's
Houston office clients, where Enron was headquartered, experienced an even stronger negative
market reaction than Andersen's non-Houston clients.2 Overall, CP concludes the shredding
announcement had a significant impact on the perceived quality of Andersen's audits, and that
the resulting loss of reputation had a negative effect on the market values of the firm's other
clients. In this study, we report new findings that shed light on whether this event study
evidence is consistent with an auditor reputation effect. In so doing, we do not suggest that
auditor reputation does not matter. As discussed above, there is ample evidence that
reputation is important to auditors and their clients. Rather, our purpose is to determine
whether client returns around Andersen's shredding announcement and related events can be
considered evidence of a reputation effect, or whether the results are confounded by other
effects.

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Partners in crime
KENNETH L. LAY and his second in command, Jeffrey K. Skilling, were the public faces of Enron,
painting a rosy picture of strong profits and healthy businesses. But as the facts began to
tumble out, in the fall of 2001, the company swiftly collapsed, taking with it the fortunes and
retirement savings of thousands of employees.

Mr. Lay, as founder and chairman is accused of seven counts of fraud and conspiracy, and Mr.
Skilling, his chief executive, who faces dozens of counts, including fraud, conspiracy and insider
trading.While they are probably the best known of the Enron characters, there were many
others who played supporting roles. Some have admitted to helping artificially increase profits
and hide losses and debts. Others tried to blow the whistle on the deceptions.

Andrew S. Fastow The Finance Chief Who Turned to Fraud

Andrew S. Fastow, Enron's chief financial officer, avoided the spotlight, leaving that to Mr. Lay
and Mr. Skilling.But Mr. Fastow, who was one of Mr. Skilling's first hires at Enron in 1990,
proved his importance to the company in another way: he raised the huge amounts of capital
that Enron needed as it moved beyond its roots in the natural gas business to blaze trails as an
innovative energy powerhouse.

At the same time, as Mr. Fastow acknowledged in his guilty plea two years ago, he also worked
with other senior officers to disguise Enron's deteriorating finances. Specifically, he helped to
set up complex off-the-books partnerships that Enron used to avoid disclosing losses. He also
used the used the partnerships, he admitted, to defraud Enron of millions of dollars for his own
benefit.

Ben F. Glisan Jr

Ben F. Glisan Jr. joined Enron in 1996 after a brief stint at Arthur Andersen, where he worked
primarily on the Enron account. He became part of the inner circle and helped conceive and
execute several financing schemes that hid company losses.Mr. Glisan was appointed corporate

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treasurer in 2000, a move that Sherron S. Watkins, a former Enron vice president, later
described to Congress as "effectively letting the foxes in the henhouse."

Mr. Glisan and Mr. Fastow were among four senior Enron executives who secretly invested in a
partnership known as Southampton Place. Mr. Glisan invested $5,800, which returned close to
$1 million in a matter of weeks. He later forfeited all of it.

Mark E. Koenig

It was an infamous conference call, and Mark E. Koenig had allowed it to happen on his watch.
On that day in April 2001, Mr. Koenig, then the director of investor relations at Enron, was
managing a call between Enron's executives and Wall Street analysts. Mr. Skilling began by
laying out Enron's performance in the first quarter. The company was reporting $425 million in
earnings, he said, another banner quarter.

But the call turned tense during an exchange between Mr. Skilling and a hedge fund
representative. Mr. Skilling ended the verbal joust by describing, on an open line, the hedge
fund man in profane language. (Transcripts of the call can still be found on the Internet.)
Something must be awry if Enron's chief executive acted so erratically, Wall Street surmised,
and Mr. Koenig, a longtime Enron veteran, had not been able to forestall it.

Mr. Koenig, now 50, joined Enron in 1985. Although he stayed at the company until spring 2002,
past its bankruptcy filing in December 2001, prosecutors say he participated in and knew about
efforts to mislead investors into thinking that the company was financially healthy.

By August 2004, Mr. Koenig pleaded guilty to a count of aiding and abetting securities fraud, a
charge punishable by up to 10 years in prison. He also settled separate civil charges, paying
almost $1.5 million in fines and forfeitures. More important, as he awaits sentencing, Mr.
Koenig agreed to cooperate in the case against his former bosses.

Lou Lung Pai

Lou Lung Pai headed several divisions at Enron, including Enron Energy Services, which sold
contracts to provide natural gas and electricity to companies for long periods. Born in Nanjing,

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China, he emigrated with his parents to the United States when he was 2. He earned a master's
degree in economics at the University of Maryland and worked for the Securities and Exchange
Commission before joining Enron in 1986.

Regarded by colleagues as prickly, Mr. Pai (pronounced "pie") was also known for running up
large bills on the company expense account at strip clubs. His affair with an exotic dancer ended
his marriage in 1999, and he sold most of his Enron shares to settle the divorce. Mr. Pai's take,
more than $271 million, is the largest of any former Enron employee and has made him the
target of several shareholder lawsuits.

Mr. Pai, who resigned from the company six months before it filed for bankruptcy protection,
has been questioned by federal prosecutors and S.E.C. investigators but has not been charged
with wrongdoing. Through his lawyers, he has said he was not involved in promoting Enron
stock and denies knowledge of any illegal, off-the-books accounting. His name appears on a list
of potential witnesses for the defense in the trial of Mr. Lay and Mr. Skilling.

Kenneth D. Rice

Kenneth D. Rice held several posts during his 20-year career at Enron, including chief executive
of its high-speed Internet unit. Raised on a farm in Broken Bow, Neb., Mr. Rice earned a degree
in electrical engineering from the University of Nebraska and an M.B.A. from Creighton
University in Omaha.

With his boyish good looks and rakish ways, he was known as a consummate salesman. Mr.
Rice raced Ferrari and motorcycles and was a favorite of Mr. Skilling, accompanying him on trips
to Patagonia, the Australian Outback and Baja, Mexico.

He was indicted in 2003 on more than 40 charges, including fraud and conspiracy. He and other
executives in Enron's broadband division were accused of making misleading statements about
the capabilities of the technology and the performance of their division, resulting in an artificial
inflation in the value of Enron stock. Mr. Rice then sold the stock at those high prices, the
indictment said; he sold 1.2 million shares for more than $76 million. Mr. Rice pleaded guilty in
2004 to one count of securities fraud and agreed to cooperate with federal prosecutors. The

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other charges were dropped. The length of his jail term will depend on how helpful he is to
government investigators.

He testified at a trial last year against co-workers accused of fraud at Enron's broadband unit.
The jury was unable to reach a verdict, and the case is to be retried in September.

Mr. Rice is also expected to testify against Mr. Lay and Mr. Skilling. Moreover, Mr. Rice is a
defendant in several shareholder lawsuits. With his plea, he agreed to forfeit a vacation home
in Telluride, Colo., cars, cash and other property totaling $13.7 million.

Greg Whalley

Greg Whalley, Enron's former president, once created a hypothetical futures contract for
Popsicles.After cornering the market from his fellow Enron traders, he arranged for a truckload
of real Popsicles to be delivered to the trading floor as "payment" for his fellow traders. The
truck broke down along the way, but the Popsicles arrived intact.

The Popsicles were just one way that Mr. Whalley, a former tank captain in the Army, loosened
up his fellow traders and became a popular figure within Enron's burgeoning energy trading
operation. Brash but fun-loving, Mr. Whalley was a fast-rising star. He joined the company in
1992 as a new graduate of Stanford's business school and rose to the top of the wholesale
trading division.

In August 2001, after Mr. Skilling left the company, Mr. Lay tapped Mr. Whalley to be the
company's president. Weeks later, after he realized the depth of Enron's financial woes, Mr.
Whalley fired Mr. Fastow without even waiting for formal approval from the company's board.

Mr. Whalley, 43, did not return phone calls or e-mail messages seeking comment.

Since Enron's collapse, Mr. Whalley has been questioned by federal investigators and sued by
investors. He has cooperated with investigators, but the legal cloud over him led a Swiss bank,
UBS, to let him go shortly after it acquired Enron's trading operation in 2002.

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He later landed at Centaurus Energy, the Houston hedge fund founded by John Arnold, who
worked under Mr. Whalley at Enron as a natural gas trader. At Centaurus, he is in charge of
developing new trading strategies, said one former Enron manager in the trading operation.

Rebecca Mark

Globe-trotting in stiletto heels and a miniskirt, Rebecca Mark was Enron's flashy ambassador
abroad. A media darling in the late 1990's, she ran various international business development
divisions within the company

Originally from a small town in Missouri, Ms. Mark was twice listed on Fortune's annual index of
the 50 most powerful women in business and was widely reported to have been a rival of Mr.
Skilling's to be named chief executive. But she later became the subject of scorn because of bad
bets, like a $3 billion investment in a power plant in India, which provoked accusations that
Enron had negotiated an unfair deal with the local government.

Ms. Mark was forced to resign in August 2000 when she was chief executive of Azurix, a
fledgling and financially shaky Enron water subsidiary. She sold her shares in Enron shortly after
she left, receiving $82.5 million.

Last year, Ms. Mark agreed to pay $5.2 million, which was her share of a $13 million settlement
with Enron shareholders, although a judge earlier found no impropriety in the millions from her
Enron stock sales.

She cooperated with a Senate committee that investigated Enron improprieties in international
deals and it is generally thought that she will be a witness in the trial of Mr. Lay and Mr. Skilling.
But she is not on the government's current witness list, and her lawyer says she has not been
subpoenaed.

Among the people who battled the crime

Sherron S. Watkins

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She is remembered for the letter she wrote as a company vice president in August 2001 to Mr.
Lay, describing improper accounting practices at Enron. Months later, Enron collapsed. Ms.
Watkins's prescient letter, made public in the Congressional investigation into the company's
collapse, brought her fame as a corporate whistle-blower.

Vincent J. Kaminski

Sounding the Alarm But was Unable to Prevail . For months before Enron's demise, Vincent J.
Kaminski warned superiors that the off-the-books partnerships and side deals engineered by Mr.
Fastow were unethical and could bring down the company. As Enron's managing director for
research, Mr. Kaminski was responsible for quantitative modeling to assist the energy traders
and other parts of the business.

Mr. Kaminski's disgust with Mr. Fastow's deals eventually exploded into an internal war with
Enron's global finance department in the fall of 2001. As his anger mounted, he refused to sign
off on documents related to the partnerships known as the Raptors that Mr. Fastow had
created, and he instructed his team of internal Enron consultants to refuse to do any work for
the finance department.

His efforts fell on deaf ears. Earlier, in March 2001, he went to Mr. Glisan, the company's
treasurer, and presented a report from a midlevel analyst saying that Mr. Fastow's deals had
created a threat to Enron's survival, in part because of stock price "triggers" that would require
bank loans to be repaid if Enron's credit rating was downgraded and the stock price fell.

Mr. Kaminski is well known in the energy industry for his loyalty to the brainy minds he often
recruited from top universities worldwide. As Enron was collapsing, Mr. Kaminski helped all 50
of his former research staff members find jobs elsewhere.

Summarized process and final fate of ENRON.

Process

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As the boom years came to an end and as Enron faced increased competition in the energy-
trading business, the company’s profits shrank rapidly. Under pressure from shareholders,
company executives began to rely on dubious accounting practices, including a technique known
as “mark-to-market accounting,” to hide the troubles. Mark-to-market accounting allowed the
company to write unrealized future gains from some trading contracts into current income
statements, thus giving the illusion of higher current profits. Furthermore, the troubled operations
of the company were transferred to so-called special purpose entities (SPEs), which are
essentially limited partnerships created with outside parties. Although many companies
distributed assets to SPEs, Enron abused the practice by using SPEs as dump sites for its troubled
assets. Transferring those assets to SPEs meant that they were kept off Enron’s books, making its
losses look less severe than they really were. Ironically, some of those SPEs were run by Fastow
himself. Throughout these years, Arthur Andersen served not only as Enron’s auditor but also as
a consultant for the company.

The severity of the situation began to become apparent in mid-2001 as a number of analysts
began to dig into the details of Enron’s publicly released financial statements. An internal
investigation was initiated following a memorandum from a company vice president, and soon
the Securities and Exchange Commission (SEC) was investigating the transactions between
Enron and Fastow’s SPEs.

As the details of the accounting frauds emerged, the stock price of the company plummeted from
a high of $90 per share in mid-2000 to less than $1 by the end of November 2001, taking with it
the value of Enron employees’ 401(k) pensions, which were mainly tied to the company stock.
Lay and Skilling resigned, and Fastow was fired two days after the SEC investigation started.

Final fate of the company

On December 2, 2001, Enron filed for Chapter 11 bankruptcy protection. Many Enron
executives were indicted on a variety of charges and were later sentenced to prison. Arthur
Andersen came under intense scrutiny and eventually lost a majority of its clients. The damage

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to its reputation was so severe that it was forced to dissolve itself. In addition to federal
lawsuits, hundreds of civil suits were filed by shareholders against both Enron and Andersen

The company employees shocked with the incident were dispersed in thousands in search for
new jobs.

The scandal also resulted in a wave of new regulations and legislation designed to increase the
accuracy of financial reporting for publicly traded companies. The most important of those
measures, the Sarbanes-Oxley Act (2002), imposed harsh penalties for destroying, altering, or
fabricating financial records. The act also prohibited auditing firms from doing any concurrent
consulting business for the same clients.

Lessons to be learned from Enron's downfall

o There are still several important lessons for investors to take from the Enron
scandal. First, it's critical not to have too much of your portfolio invested in a
single stock. No matter how compelling the company's story might be, the threat
of a reversal that you could never predict can wipe you out if you have too much
of your money invested in it.

o Second, company employees should be especially cautious about buying their

employer's stock. It's tempting to invest in a business you know well, but if
something goes wrong, you risk both losing your primary source of income and
taking a big hit in your investment portfolio at the same time.

o Finally, make sure you understand how a company's business works. Most
shareholders couldn't understand Enron's sophisticated trading business, but they
didn't really care as long as the stock was moving higher. That left them
completely vulnerable to changes in the fundamental health of the business in
which Enron was operating. Between the high levels of leverage, complicated
derivatives, and management that turned out to be questionable in its honesty and
integrity, Enron provided some warning signs to those willing to listen, and

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shareholders could have avoided some of the damage from the scandal if they'd
steered clear.

o Seventeen years after the energy company's bankruptcy filing, the Enron scandal
still has an influence on the investing world. By recognizing that similar risks still
exist today, you can remain vigilant and protect yourself from future scandals

Sources

 Wikipedia

 https://www.britannica.com

 https://www.thebalancesmb.com

 https://www.investopedia.com

 www.nytimes.com

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